This blog covers financial, political and other topics the author gets the urge to write about. It does not provide personal financial, legal or other advice. Consider consulting a personal professional adviser before making any decisions. Copyright (c) 2007, 2008, 2009, 2010, 2011, 2012, 2013, 2014, 2015, 2016, 2017, 2018, 2019 by Leonard W. Wang. All rights reserved.

Tuesday, February 17, 2009

We have an Expanded Bank Bailout and a Stimulus Package. So What Have You Done For Us Lately?

President Obama has done remarkably well in his first four weeks. His administration revamped the financial sector bailout, significantly expanding its focus, and pushed a $787 billion stimulus package through Congress. This is more than his predecessor accomplished in two years. Nevertheless, the Dow Jones Industrial Average fell 297 points today. Percentage-wise, the Nasdaq and S&P 500 averages fell even more. There's gratitude for you.

Many commentators, foreign and domestic, believe that the current measures are inadequate. They point to accelerating economic decline in America and around the globe, and less than exuberant stimulus measures proposed by other nations. Perhaps the only country that is going farther than the U.S. in stimulating its economy is China, and China's economy is too small to serve as a locomotive for the rest of the world.

So the U.S. government probably will have to do more. Given the accelerating global downturn, it may have to act sooner rather than later. But we're now getting to the point where things get complicated (more so than they are already).

First, let's look at the bank bailout problem. Mortgage relief is a priority on the administration's agenda. There is talk about subsidizing mortgage modifications with federal assistance that induces banks to give borrowers breaks before they default. And bankruptcy judges may get the authority to rewrite mortgages. These measures could force banks to take more writedowns, as mortgages they've been carrying at optimistic values are modified. The more writedowns the banks take, the more federal capital they will need for recapitalization. So, federal measures to alleviate mortgage problems may well increase the cost of the bank bailout, above and beyond the $50 billion already allocated for mortgage relief.

Another dilemma is the toxic asset problem. Everyone agrees that these assets must be removed from the major banks' balance sheets if the banks are to be restored to health. But these assets are becoming ever more toxic as the economy continues to decline, so the cost of removing them increases by the day. The major banks could be carrying as much as a trillion dollars in toxic assets on their balance sheets. Moreover, the largest portion of toxic assets isn't even shown on bank balance sheets, but rather is held in off-balance sheet vehicles for which the banks have some liability. These off-balance sheet assets may amount to perhaps another two, three or four trillion dollars. All told, the toxic asset problem could absorb trillions of federal dollars. Treasury Secretary Geithner has proposed raising private capital to join with federal capital to buy up the toxic financial waste. But it remains to be seen whether the federal contribution ($50 billion) can bring in enough private capital to put a meaningful dent in the problem. Secretary Geithner has talked about raising $500 billion (or more) in private capital. The investors that would buy toxic assets are Wall Street pros who would make Las Vegas card counters look angelic. They may not see a 9% federal buffer as much of an inducement in a declining economy to buy some of the most volatile of financial assets, especially at prices the federal government would like to pay. The government would probably not want to bargain hard for the toxic assets because low prices would increase the federal costs of recapitalizing the banks. But private investors would want to low ball the banks, because on Wall Street money talks and bull chips walk. With this inherent conflict, how will Secretary Geithner's public-private partnership work?

For better or for worse, and very reluctantly, the government will probably nationalize most of the major banks, at a cost that will run into trillions. Perhaps a few very healthy banks will remain independent. But those bedeviled by toxic assets will likely end up in federal receivership. Then the toxic assets will belong to the taxpayers. Let's hope that federal stewardship seeks to maximize taxpayer profits on them.

With the true cost of the bank bailout likely to be trillions, how much will be left for additional economic stimulus? Nothing is forever, which in this context means that there is a limit to how much money the federal government can borrow or print. No one today knows exactly where that limit is. But just as the real estate market couldn't continue to rise forever, America's solvency can't be taken for granted. If history is any guide, consider the Spanish Empire. In the 1500s, gold and silver from the conquered Aztec and Inca empires made Spain the wealthiest and most powerful nation in Europe. But all this precious metal led Spain to invest heavily in New World mines, and not so much in manufacturing. Meanwhile, the poorer but more industrial-minded nations in northern Europe concentrated on manufacturing, rising to power in the 1600s as Spain unhappily learned that financial assets alone don't produce lasting wealth. The rest is history, as northern Europe to this day remains an important manufacturing center while Spain has lagged.

It's said that there can't be an economic recovery without a sound banking system. That's true, but it doesn't present the complete picture. A sound banking system alone doesn't produce a healthy underlying economy. Look at the Great Depression. Thousands of banks failed in the early 1930s, until FDR's administration created the Federal Deposit Insurance Corporation in 1933. Once the safety of deposits was guaranteed, bank failures diminished significantly. But the U.S. remained mired in depression for the remainder of the 1930s. Not until America began rearming in 1939 and 1940 in anticipation of its likely entry into World War II did the nation achieve a lasting recovery. Simply stabilizing banks didn't bring prosperity.

If we spend trillions for bank bailouts and mortgage relief, where will we get the money to rebuild the real economy? The Federal Reserve has been printing bucketsful of money in order to assist banks and other financial institutions. The Treasury is embarking on the biggest borrowing spree since World War II. We need to make some careful decisions about how to allocate the trillions that the federal government will be spending in the next few years. Giving the financial sector a blank check while placing the real economy on short rations isn't the best answer. At some point, the financial system's creditors (other than insured depositors) should take losses if that's what is necessary to get the unemployed back to work. Most of the creditors are financial professionals or wealthy people who, in lending to banks, did understand or should have understood they were taking risks. Most of the unemployed are innocent victims of a financial drive-by shooting. FDR brought compassion back to the government's policies, and that more than anything else spawned hope.

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